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Want a winning portfolio? Just avoid the biggest loser

People generally assume that the goal in investing is to pick winners. Often though, a profitable approach is to simply avoid the biggest losers.

For example, through mid-December the S&P 500 had posted a year-to-date return of 8.3 percent. However, this return was dragged down significantly by the worst-performing sector, energy, which had posted a loss of 16.5 percent. If you had eliminated that sector from your portfolio, you would be doing significantly better than the overall index return. Think of it as addition by subtraction.

Losing the losers

This approach has the potential to succeed because sometimes it is easier to spot trouble than it is to see where the next boom is going to be. Here are some other reasons to like the addition-by-subtraction approach.

Bad sectors tend to vary more from the index return than good sectors. Through early December, the energy sector was trailing the S&P 500's return by 24.8 percent, whereas the best sector (heath care) was beating the index by 15.2 percent. In 2013, the worst sector (telecommunications) trailed by 23.5 percent, while the best sector (consumer discretionary) beat the index by 11.4 percent. In 2012 it was utilities that trailed by 14.71 percent, while the top-performing financial sector led by 12.82 percent. In each of these cases, the biggest loser was a more significant performance factor than the biggest winner.

Heavily weighted sectors can prove especially costly. A single sector can be around 20 percent of the index, so when one of these heavily weighted sectors underperforms, it can be especially costly unless you were able to reduce or eliminate your exposure to that sector.

Eliminating one sector can still leave you with a well-diversified portfolio. Trying to pick winners can leave you with an overly concentrated portfolio, whereas simply eliminating one sector will still leave you with nine others to own.

You don't have to be perfect to win. Even if you don't succeed in picking the absolute worst sector, as long as you pick one of the underperforming sectors, your portfolio will do better than average.

Addition-by-subtraction can be an appealing investment approach, but there is one potential drawback.

The catch

No investment approach is foolproof, and the potential catch with this one is that if you eliminate the wrong sector, you will probably underperform the market. That may happen at times, because often the sectors that experience the most dramatic collapses are those that first experience a pricing bubble. So, if you identify such a sector as risky, you may have to live with underperformance if the bubble does not burst right away.

Fortunately, this is where individual investors actually have an advantage over the professionals. Professional investment firms are under tremendous pressure from their clients not to underperform, and thus are sometimes reluctant to be out of a hot sector, even if they think it will eventually be for the best. As an individual investor answerable only to yourself, you can ignore that kind of pressure and act on your best judgement.

Since this approach is based on avoiding trouble, long-term outperformance is not the only potential benefit. If you prove effective at avoiding the losers, you will also expose your portfolio to far less risk.

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